Businesses that need to buy significant quantities of aluminum can hedge against rising aluminum price by taking up a position in the aluminum futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of aluminum that they will require sometime in the future.
To implement the long hedge, enough aluminum futures are to be purchased to cover the quantity of aluminum required by the business operator.
An aluminum mill will need to procure 2,500 tonnes of aluminum in 3 months' time. The prevailing spot price for aluminum is USD 1,470/ton while the price of aluminum futures for delivery in 3 months' time is USD 1,500/ton. To hedge against a rise in aluminum price, the aluminum mill decided to lock in a future purchase price of USD 1,500/ton by taking a long position in an appropriate number of LME Aluminum futures contracts. With each LME Aluminum futures contract covering 25 tonnes of aluminum, the aluminum mill will be required to go long 100 futures contracts to implement the hedge.
The effect of putting in place the hedge should guarantee that the aluminum mill will be able to purchase the 2,500 tonnes of aluminum at USD 1,500/ton for a total amount of USD 3,750,000. Let's see how this is achieved by looking at scenarios in which the price of aluminum makes a significant move either upwards or downwards by delivery date.
With the increase in aluminum price to USD 1,617/ton, the aluminum mill will now have to pay USD 4,042,500 for the 2,500 tonnes of aluminum. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,617/ton. As the long futures position was entered at a lower price of USD 1,500/ton, it will have gained USD 1,617 - USD 1,500 = USD 117.00 per tonne. With 100 contracts covering a total of 2,500 tonnes of aluminum, the total gain from the long futures position is USD 292,500.
In the end, the higher purchase price is offset by the gain in the aluminum futures market, resulting in a net payment amount of USD 4,042,500 - USD 292,500 = USD 3,750,000. This amount is equivalent to the amount payable when buying the 2,500 tonnes of aluminum at USD 1,500/ton.
With the spot price having fallen to USD 1,323/ton, the aluminum mill will only need to pay USD 3,307,500 for the aluminum. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the aluminum futures price will have converged with the aluminum spot price and will be equal to USD 1,323/ton. As the long futures position was entered at USD 1,500/ton, it will have lost USD 1,500 - USD 1,323 = USD 177.00 per tonne. With 100 contracts covering a total of 2,500 tonnes, the total loss from the long futures position is USD 442,500
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the aluminum futures market and the net amount payable will be USD 3,307,500 + USD 442,500 = USD 3,750,000. Once again, this amount is equivalent to buying 2,500 tonnes of aluminum at USD 1,500/ton.
As you can see from the above examples, the downside of the long hedge is that the aluminum buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising aluminum prices while still be able to benefit from a fall in aluminum price is to buy aluminum call options.
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